02 March 2013

Paul N Goldschmidt: Limiting bank bonuses - Why the choices of the new Regulation are flawed

Nevertheless, the provisions concerning the capping of bank bonuses leaves one with a feeling of uneasiness because they are discriminatory as well as too easy to circumvent. In, addition, they appear to be grounded, at least partially, in the desire to satisfy populist calls for “punishment” for obscene levels of pay; some proponents are also accused of wishing to stigmatise the “eurosceptic” attitude of the UK by aiming at the “City” on a subject unlikely to find much popular British sympathy.

There is no doubt whatsoever that the banking sector deserves strict regulatory supervision and enforcement. In this respect, one should commend the steps taken to implement the “Banking Union”. However, limiting remuneration exclusively for banks is discriminatory. To the fullest extent possible, such rules should be broadly applicable and aimed at aligning the interests of all stakeholders, including staff, management, shareholders, clients and, in the specific case of banks, taxpayers as ultimate guarantors of depositors.

Setting pay, above a certain level to be determined by law/regulation (but that bylaws could lower), should be the exclusive prerogative of shareholders, as suggested in the Swiss referendum. The new proposals do, indeed, involve shareholders when “bank” bonuses exceed base salary, which is a step in the right direction but does, however, curtail their freedom.

Alternative rules, applicable to all undertakings, such as fixing by law the ratio (but that bylaws could lower) of the “bonus pool” to its “taxable profits”, would be more effective and also seen as socially more acceptable:

a) Limiting the ratio to the available “bonus pool” preserves the prerogatives of management to incentivise correctly deserving staff.

b) Ownership rights of shareholders are protected.

c) Attempts to lower taxable profits will limit the available bonus pool.

An additional possibility would be to limit, within the “bonus pool”, the cash distribution as a % of dividend payouts. Amounts remaining in the pool could only be distributed in the form of “shares” with restricted liquidity over, say, a five-year period.

It is clear that, because of its systemic nature, the banking sector should be subject to close scrutiny over its remuneration policies, going further than the mere compliance with the rules suggested above. For instance, bonuses (and dividends) should be restricted automatically if key solvency/liquidity ratios are not met. In addition, non-compliance with parameters, including correct weighting of risk assets, concentration of exposures, counterparty risks, etc., should be sanctioned by subjecting bonus/dividend distributions to prior regulatory approval. Such requirements are non discriminatory.

Turning to the question of circumventing the new regulations, the simplest way is to increase base salaries. This will burden the banking sector with higher fixed costs and make it more vulnerable to economic cycles; it will require additional amounts of equity reducing profitability; it will increase the cost - and/or inhibit the amount - of lending and, last but not least, subject the EU banking sector to increased competition.

An alternative avoidance scheme is to redefine the concept of “salary”. Instead of a fixed contractual amount, a salary can be considered to be a combination of a very low minimum guaranteed amount and a “commission” based on a parameter linked to profitability (individual or team based). The bonus then kicks in on top to reward outstanding performance. Finally, especially for international groups, it will always be possible to structure pay deals to include board memberships of - or services provided to - entities falling outside of the regulatory perimeter.

To mitigate the adverse effects of such behaviour, regulatory requirements covering banks should include the obligation of filing with their home tax authorities and those of the “fiscal residence” of any individual earning/receiving more than the equivalent of €250,000 per annum, the details of the “total remuneration package”. (This rule should be extended broadly to all undertakings.)

Needless to say, the more even-handed approach to bonus regulation suggested above would make enforcement far more effective. It would also go a long way to address the problem of the growing feeling of injustice deriving from the increasing gap between haves and have-nots; it would also remove accusations of “City” bashing.

Paul N Goldschmidt - Director, European Commission (ret); Member of the Advisory Board of the Thomas More Institute

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© Paul Goldschmidt